Small business owners or independent contractors pay themselves out of the business profits. From a tax perspective, this idea is a myth. However, from a budgeting perspective, paying yourself is a necessity. It’s critical to understand the differences between these two concepts and how your business structure can affect them.
Small Business Profits
If you are a freelancer, an independent contractor or any other type of self-employed individual, the Canada Revenue Agency treats you as a small business owner. You must report all of the revenue you collect as income, but you can write off business expenses. Similarly, if you have employees, you pay them from your business coffers, and you get to claim their wages as a deduction on your tax return.
However, as a small business owner, you cannot pay yourself. From a legal perspective, you and your business are the same entity. To that end, if your business has debts, you are personally liable for them, and if your business has profits, all of those profits are considered to be your income. When you file your tax return, you report your business revenue and expenses on Form T2125 and transfer your business profits to the income section of your T1 general tax return.
There is one key exception relating to incorporated businesses. If you ultimately decide to incorporate your business, that process separates you from the business. You are no longer personally liable for your business’s debts; by extension, if you default on a business loan, the lender cannot attempt to repossess your personal assets.
If your small business is incorporated, its profits are no longer your income. Rather, you can draw a salary from the business and report that salary as income. Your business, in turn, must file a T2 corporate income tax return and pay income taxes on its profits.
Budgeting Your Pay
Even if you decide not to incorporate your business, you may still want to budget your own pay. Ideally, as a small business owner, you should have a separate bank account for your business so you can deposit revenues and pay for business expenses. If you dip into that account every time you need money for personal reasons, you may short-change your business and unnecessarily compromise its cash flow.
Instead, use your accounting software to set up regular monthly or weekly payments for yourself. The cheques should be small enough so you leave a healthy reserve in your business account but large enough to cover your personal financial needs. As your business grows, you may want to increase how much you pay yourself or make sure you have enough money in your account to cover vacation weeks where you don’t work but you pay yourself anyway. If you have unused profits at the end of the year, you can give yourself a bonus, reinvest that money into your business and claim a tax deduction for the expenses, or simply leave the funds for emergencies in the new year.